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When Will U.S. Inflation Return to Target? James Bullard President and CEO Economic Update Breakfast Nov. 14, 2017 Louisville, Ky. Any opinions expressed here are my own and do not necessarily reflect those of the Federal Open Market Committee. 1 Introduction 2 Key themes in this talk • • • • Inflation in the U.S. has surprised to the downside this year. U.S. real economic performance has been better during the second half of 2017, but 2018 growth is expected to slow. U.S. financial conditions are considered easy, but this observation does not have strong predictive content for the economy. Implications for near-term U.S. monetary policy: The current level of the policy rate is likely to remain appropriate over the near term. 3 The 2017 Inflation Surprise 4 U.S. inflation in 2017 • • * The U.S. inflation rate has been below the 2 percent inflation target since 2012.* Inflation data during 2017 have surprised to the downside and call into question the idea that U.S. inflation is reliably returning toward target. The inflation target is in terms of the annual change in the price index for personal consumption expenditures (PCE). 5 U.S. inflation has been mostly below target since 2012 Source: Bureau of Economic Analysis. Last observation: September 2017. 6 Smoothed inflation readings are lower in 2017 Inflation measure Dec-2016 Last obs. Difference Sticky CPI (FRB of Atlanta) 258 212 -46 Median CPI (FRB of Cleveland) 250 217 -33 Core CPI 220 170 -50 Trimmed-mean PCE (FRB of Dallas) 191 163 -28 Core PCE 187 133 -54 Values are expressed in basis points. Inflation rates are measured as percent changes from one year earlier. Sources: Bureau of Labor Statistics, FRB of Cleveland, FRB of Atlanta, Bureau of Economic Analysis, FRB of Dallas and author’s calculations. Last observation: September 2017. 7 Trimmed-mean PCE inflation lower than expected Sources: FRB of Dallas and author’s calculations. Last observation: September 2017. 8 Core PCE inflation lower than expected Sources: Bureau of Economic Analysis and author’s calculations. Last observation: September 2017. 9 The FOMC’s take on the 2017 inflation surprise • The Federal Open Market Committee (FOMC) makes projections for core PCE inflation. • The current median projection for core PCE inflation is 1.5 percent at the end of 2017.* • If the Committee is going to hit the inflation target, it will likely have to occur in 2018 or 2019. • The two most cited factors that could drive inflation higher are inflation expectations and a faster pace of economic expansion. • Let’s now turn to considering these factors. * See the September 2017 Summary of Economic Projections. 10 Inflation Expectations 11 Inflation expectations remain low • One important influence on actual inflation is the state of inflation expectations. • Expected inflation measures based on Treasury InflationProtected Securities (TIPS) remain relatively low. • • Survey-based measures have also slipped in the last year. Inflation expectations are sometimes sensitive to movements in oil prices, and oil prices have increased in recent trading. 12 Market-based inflation expectations • TIPS-based inflation compensation is based on headline consumer price index (CPI) inflation. • Survey-based measures are less specific about the inflation index. • Historically, CPI inflation has run somewhat higher than PCE inflation, with an adjustment of about 30 basis points at an annual rate.* • Other factors can influence TIPS-based expected inflation. * This adjustment is conservative. The difference between CPI and PCE inflation since January 1960 was, on average, 46 basis points. 13 Market-based inflation expectations Source: Federal Reserve Board. Last observations: Nov. 10 (breakeven inflation rates) and Nov. 3, 2017. 14 Survey-based inflation expectations Source: Surveys of Consumers, University of Michigan. Last observation: November 2017. 15 Oil prices and inflation • Global oil prices fell dramatically during 2014 and then stabilized. • Headline inflation and inflation expectations can be sensitive to oil price movements. • Recent trading has generated upward movements in oil prices due in part to political developments in Saudi Arabia. • U.S. production, which is substantial, tends to increase when prices rise, limiting price movements. 16 Oil prices somewhat higher since June Sources: Energy Information Administration and Financial Times. Last observations: Nov. 8 and Nov. 10, 2017. 17 U.S. as a marginal producer Source: Energy Information Administration. Last observation: August 2017. 18 Real GDP Growth Likely Slower in 2018 19 U.S. real GDP growth in 2017 • The data since the financial crisis suggest that the U.S. has converged to 2 percent real GDP growth. • The current estimate for U.S. real GDP growth in the first half of 2017 is 2.1 percent at an annual rate. • Second-half real GDP growth is showing some improvement from the first half of the year, with current tracking estimates near 3 percent. • Real GDP growth will likely be slower in 2018 than it has been in the second half of 2017. 20 The 2 percent growth regime since the recession Source: Bureau of Economic Analysis. Last observation: 2017-Q3. The shaded area indicates NBER recession. 21 Tracking estimates for 2017-Q4 U.S. real GDP growth Source Date Estimate* 2017† Atlanta Fed GDPNow Nov. 9 3.3% 2.6% CNBC Moody’s Consensus (median) Nov. 9 2.8% 2.5% Blue Chip Consensus Nov. 10 2.7% 2.5% St. Louis Fed Economic News Index Nov. 10 3.0% 2.6% FRBNY Staff Nowcast Nov. 10 3.2% 2.6% Macroeconomic Advisers Nov. 10 2.5% 2.4% * percent change from the previous quarter, annualized average of Bureau of Economic Analysis’ 2017-Q1, Q2, Q3 estimate (1.2%, 3.1% and 3%, respectively) and 2017-Q4 estimates † 22 2018 real GDP growth Sources: FRB of St. Louis, FRB of Atlanta, Federal Reserve Board, International Monetary Fund and Blue Chip Economic Indicators. Note: For 2017 and 2018, growth rates are Q4-on-Q4 except for the World Economic Outlook (y-on-y). 23 U.S. labor market performance • • • The pace of growth in employment has been generally slowing since January 2015. The unemployment rate is relatively low. The statistical relationship between unemployment and inflation has broken down during the last 20 years. o This means low unemployment is probably not a harbinger of higher inflation. 24 Employment growth has slowed since 2015 Sources: Bureau of Labor Statistics and author’s calculations. Last observation: October 2017. 25 The unemployment rate is low Sources: Bureau of Labor Statistics and author’s calculations. Last observation: October 2017. The shaded area indicates NBER recession. 26 Will low unemployment drive inflation higher? • The U.S. unemployment rate was 4.1 percent in the October reading. • Does this mean that U.S. inflation is about to increase substantially? • The short answer is no, based on current estimates of the relationship between unemployment and inflation. 27 The estimated influence of unemployment on inflation • Let’s consider one study, Blanchard (2016), which estimates a Phillips curve relationship for the U.S.* • Let’s suppose the unemployment rate continued to fall from current levels. • How much would the inflation rate increase according to these estimates? * See O. Blanchard, 2016, “The U.S. Phillips Curve: Back to the 60s?” Peterson Institute for International Economics, Policy Brief No. PB16-1. 28 The estimated influence of unemployment on inflation * If the unemployment rate was … The predicted core PCE inflation rate would be … 4.1% * 1.3% * 4.0% 1.3% 3.5% 1.4% 3.0% 1.5% current value (October 2017 for unemployment, September 2017 for inflation) • Bottom line: Even if the U.S. unemployment rate declines substantially further, the effects on U.S. inflation are likely to be small. 29 U.S. Financial Conditions 30 U.S. financial conditions are easy • • • U.S. financial conditions are considered easy, or “low stress,” according to commonly used indexes. The indexes take into account factors such as market volatility (which has been low) and interest rate spreads (which have been relatively narrow). However, these indexes have an important asymmetry: o High-stress readings are associated with economic weakness. o Low-stress readings do not reliably predict future economic outcomes. o The current low readings probably do not contain any important signal at this point. 31 Financial conditions have improved during the past year Sources: FRB of St. Louis and Goldman Sachs. Last observations: Week of Nov. 3, and Nov. 9, 2017. Note: Lower readings mean improved financial conditions. 32 Conclusion 33 Conclusion • • • • • Inflation has surprised to the downside in 2017. Inflation expectations remain below the level that would be historically consistent with the FOMC’s inflation target. Real GDP growth looks like it may surprise to the upside during the second half of 2017 before shifting toward slower growth in 2018. Low unemployment readings are probably not an indicator of meaningfully higher inflation over the forecast horizon. 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